Risk Management and Hedging Strategies
Designing a hedge
Start with the exposure: what price, currency, rate or index drives the loss? Then choose the instrument, direction, tenor and hedge ratio. A short hedge protects a seller; a long hedge protects a buyer. The hedge must be monitored and rolled before expiry. Hedging is not about making a profit; it is about reducing variance in the hedged outcome.
Hedge ratio and basis risk
The minimum-variance hedge ratio is h = ρ × (σS ÷ σF), where ρ is the correlation between spot and futures changes and σ is volatility. A cross hedge uses a related but not identical instrument, creating basis risk. Over-hedging creates a speculative position. Under-hedging leaves residual exposure.
Options strategies
A protective put sets a floor below a holding; a covered call generates premium but caps upside; a collar combines both. Delta hedging neutralises small moves but requires rebalancing as gamma changes. The exam tests whether the strategy matches the client's objective and risk tolerance.
Worked example
A portfolio is worth NZ$10 million with a beta of 1.2. Index futures trade at 12,500 with a multiplier of NZ$10, giving NZ$125,000 notional per contract. Contracts = (10,000,000 × 1.2) ÷ 125,000 = 96. Selling 96 contracts hedges the market exposure. The reasoning is that beta adjusts the portfolio's sensitivity to the index.
Traps
Treating a hedge as a profit centre; forgetting basis risk; using the wrong beta or contract multiplier; and failing to roll or unwind the hedge.